Larry's VC View is the bi-weekly blog by photonics entrepreneur and budding venture capitalist Dr. Larry Marshall who shares his thoughts and reflections on the VC scene, as he makes the transition from serial entrepreneur and engineer, to Venture Capitalist. He hopes to share his experiences, lessons and mistakes with fellow entrepreneurs seeking venture funding.

Tuesday, August 26, 2008

Money is almost out, but there is light at the end of the tunnel. A last minute offer has come in to acquire the company and it looks like everyone will survive to fight another day.

Rewind 6 months to the painful realization that the company should not be funded again and needs to find a buyer. Should they engage a banker? (need another Blog on this). How many months did the investors & founders spend arguing over the liquidation preference and management carveout?

Typically, when the market is poor, management teams negotiate a carveout in the event of sale to overtake the liquidation preference of the investors and assure the team of some return. What’s interesting about this situation is how common it is and how it is reversing the urban myths of VCs reneging on deals. In this case management is reneging--they took the investor’s money and promised a return, agreed to preferences, probably participating preferred and liquidation, maybe anti-dilution to boot--so what’s going on here!?!

Do contracts mean nothing? Damn, sue them!!!

The only people I know who shout that are people who have never been involved in a lawsuit. Generally it's the battle cry of a fool. So the team gets a management carveout of typically 10%. I’ve seen many months wasted in this type of negotiation but it always seems to end up at 10%. I’ve also seen management argue that the investors shouldn’t get any of the earnout in the deal, unless the investors beat them to it with the argument that investors should get all their portion of the earnout up front since they have no control over the team’s ability to deliver the earnout ;-(

So let's look at what happens when the investors don’t negotiate an carveout--the acquirer has acquisition costs--the price he pays for the company, and the retention bonus for the team. If the acquirer can roll the latter into the deal price it’s a better position for them. Finisar did a number of acquisitions in the telecom downturn, and I can't think of one where they didn’t override the VC imposed carveout structure with something more suitable to the acquirer to reward the team. Earnouts rarely went to the investors, and new carveouts were imposed to reward the team and keep them in place. The counterpoint to this is obviously getting the deal done--in a competitive environment the buyer has much less chance to impose deal structures.

The upshot of all this is very simple--as an entrepreneur you can spend an inordinate amount of time negotiating complex deal structures and fretting valuation, and likewise the investors can impose all types of downside protections. But in the end value is generally rewarded. So despite liquidation preferences, anti-dilution, and a host of other issues that probably cost 6 months of painful negotiation, in the end the buyer decides who gets what.

The team is most of the value in a deal, and if they don’t get rewarded the deal doesn’t happen. So while all the power may seem to reside with the VCs because they have the money, in fact it resides with whomever delivers the value. At the time of initial funding the value is mostly the $, but once the company is established that power shifts ;-)

Tuesday, August 12, 2008

As engineers we tend to underestimate marketing--we don’t understand it well, and at a minimum we merge it with sales. Something that always surprises me about venture backed tech startups is how little they emphasise marketing. There is a lot of lip service, but look at the org chart of most tech startups going into their series B, and there will be a bloated engineering organization, one or two sales people, and no marketing. Now this can be good for burn rate; marketing can burn a frightening amount of cash, and often the CEO is the marketing person (showing at least that it’s a priority).

To give an example of the strength of marketing--Coherent, when they had a medical division, launched mixed gas lasers that made yellow light for ophthalmic applications. They could just as easily have made green lasers, but they realized that others could do that too. If you look at the absorption spectrum of hemoglobin there are two peaks in the visible, one in the yellow and a slightly smaller one in the green. From a theoretical perspective one would conclude that yellow is better--i.e., less power for more energy absorbed in same volume. So a great marketing campaign was launched to promote yellow as the magical wavelength for photocoagulation, and Coherent dominated the market.

Even more than 15 years later, most doctors, and surprisingly many engineers, still believe yellow is better and wont buy anything else--researchers still struggle with ways to create yellow, but in clinical applications the differences are barely distringuishable and from an economic perspective cost differences not justified. Just like Brand, it's an almost unbeatable argument based on belief. Whether nurtured from science or religion, the end result is additional value captured for years. To quote an oft misrepresented and misunderstood compay, dear to the hearts of all laser jocks--Novalux, making laser TV--what could be cooler than that!?!

As a quick aside to my “Is it a feature, product, or company?” Blog, Novalux could have been a company for sure, but they never managed to control the whole product solution. However, they did engineer the first ever TV solution with a hope of meeting the grinding wheels of consumer electronics (rather like CMOS, actually). They had the laser chip but they lacked the optical chip.

I am personalloy very proud of being able to acquire this company and merge it into the optical chip company to create the whole product solution. Novalux did a simply outstanding job of marketing, they convinced even the most cynical laser jocks (including me!) that laser TV was viable, they convinced the brands, and their OEMs, and darn it, they built the best looking TV I’ve ever seen. Classic marketing (not surprising for a group of ex Coherent guys ;-) ).

So at several Photonics Forum presentations I have predicted that laser TV will never happen. I am officially wrong as Mitsubishi is shipping these TVs. In fact, if Novalux could have gotten to market faster by say a year, I believe that several brands would be shipping these TVs now.

Novalux did a stellar job of marketing, which is why Arasor acquired them. The thing missing from Novalux was true partnership (see another Blog on this), which could have given them the missing piece to deliver a whole product solution to the market. The fundamental problem was they relied on third party OEMs who currently supplied the brands with product to manufacture the new laser TV product using a Novalux lisence. If Novalux could have gotten control of laser manufacture or a true partner to supply complete lasers, they could have driven the market.